Derivatives can be traded either on an exchange or off-exchange. Derivatives traded on an exchange are called exchange-traded derivatives. The primary purpose of exchanges is to provide contract standardization, anonymity, a clearing system, and a large number of participants in order to provide liquidity in a contract.
Contracts entered into through private negotiation are typically called off-exchange or Over-The-Counter (OTC) derivatives. OTC markets allow the creation of products whose risk-return characteristics closely match the needs of individual customers. Additionally, OTC markets address privacy concerns when participants do not want the terms of their trade or prospective trade advertised to the broader market.
When dealing in OTC markets, brokers typically quote custom derivative products to dealers via phone or instant messaging. This conventional method has many disadvantages. For example, when instant messaging a product to a group of dealers (traders), not every dealer will receive the product at the same time, which creates unfair advantage to those dealers who receive the product first. Also, when a product is sent to a dealer, the dealer does not immediately know if the product is new or is an update of a previous product. Further, brokers often send products out in varying formats, so that the dealer must then reformat the product information into a format that can be incorporated into the dealer's analysis system. In this regard, dealers must be able to quickly analyze a large amount of data, and thus having to compose product data into spreadsheets or otherwise reformat the data before any analysis begins is a clear disadvantage.
In OTC markets, traders are faced with the burdensome task of gathering, deciphering and consolidating all information on quoted products. In this regard, traders deal with products coming from multiple brokers and in differing formats. Also, traders conventionally have no dynamic, aggregated view of the market across brokers that updates in real-time as markets move. If the trader is away from his desk or otherwise busy, it is difficult to catch up on market events.
Another disadvantage of OTC markets is that dealers have a difficult time performing market-to-market portfolio valuation which is required to monitor profit and loss and risk exposure because of the OTC market's lack of a centralized source for current and historical prices. Further, corporate scandals demand OTC market participants have an independently auditable accounting system that marginalizes instances of non-representative pricing and data manipulation.
In general, OTC markets offer difficulties to all parties involved in such markets. For example, dealers do not have access to data for obtaining current prices of financial products or for testing trading models. Profit and loss and risk management personnel do not have access to data for price verification or to update the value of a portfolio. Further, in OTC markets, it is difficult to maintain records for compliance or for settlement of disputes.
Weather derivatives are one type of derivative typically exchanged in OTC markets. A weather derivative is a financial product whose payoff is based on a specified measured weather metric and is used to hedge the financial impact of weather fluctuations. Utility companies, such as individual power and utility companies, typically use weather derivatives as price and volumetric hedges to smooth their earnings. Other entities that use weather derivatives includes banks, hedge funds and re-insurance companies, to name a few.
Just as an option on a commodity has as its underlying asset the price of a futures contract, a weather derivative has as its underlying “asset”, a weather measure. A majority of weather derivatives traded in the U.S. are based on Heating Degree Days (HDD) or Cooling Degree Days (CDD), which are two different measures of temperature. An HDD is the number of degrees by which the day's average temperature is below a base temperature (usually 65 degrees Fahrenheit), while a CDD is the number of degrees by which the day's temperature is above the base temperature. Most weather contracts are written on the accumulation of HDDs and CCDs over a calendar month or a season so that one contract can hedge against revenue fluctuations over the concerned period. Weather derivatives can also be based on precipitation, humidity, wind speed or any other measurable weather metric
In general, there are three types of temperature derivatives, namely, futures/forward, swaps, and options. Besides the underlying variable HDD and CDD, a weather contract must specify such basic elements as the accumulation period, the underlying variable (weather metric) to be measured, the index station, or stations, which records the metric used to construct the underlying variable (typically, an airport), the tick size, i.e., the dollar amount attached to each unit of the underlying variable, and the strike price.
Although weather derivatives are effective hedging tools for energy and utility companies, they suffer the same disadvantages as other OTC derivatives. Accordingly, there is a need for a virtual OTC exchange that allows brokers and traders to input and track updates on financial products in real time and that provides an individualized communication protocol between each broker and trader, and allows a trader to view all current OTC quoted markets in a single consolidated screen.